The Effect of Reliance on International Funding on Banking Fragility: Evidence from East Asia

Abstract

The East Asian crisis highlights the importance of liquidity for smooth functioning of the banking system. It also shows the vulnerabilities that arise as a result of high dependence on international liquidity. This article empirically analyses the influx of liquidity before the crisis and illiquidity during the crisis in finding out whether banks in East Asia held ‘too little’ or ‘too much’ liquidity before and during a crisis and how their vulnerabilities to failure changed as a result of that. Instrumental Variable estimation is used to dissociate the effect of international illiquidity on banks’ liquidity risk during a crisis year. The study finds that the effect of liquidity on the probability of bank failure varies before and during a crisis. The findings also highlight the vulnerabilities of banks to failure as a result of international illiquidity and high reliance on external funding. These findings bring forward the case for stronger regulation of banks’ liquidity, which can be brought forward by better liquidity management.